Foreign Income & Taxpayers
The use of information reporting to prevent tax avoidance has been a major focus of the current administration and the IRS. Published comments regularly made by senior IRS officials to various professional organizations indicate the intent to use improved information reporting as a means to reduce tax avoidance and capture lost tax dollars. In the past year, legislation has been passed and additional guidance has been released related to foreign reporting requirements in the United States. It is important for practitioners to pay close attention to these developments to ensure that taxpayers are in compliance with the expanded requirements as they become effective. It is also important to stay informed as additional guidance is released clarifying these recent changes.
FBAR Filing Relief
In October 2008, the IRS released a revised Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), and related instructions. The new instructions added to the definition of a U.S. person the phrase “a person in and doing business in the United States.” The instructions also included in the definition of foreign accounts those accounts in which the assets are held in a commingled fund and the account owner holds an equity interest in the fund (including mutual funds). These changes, as well as the issuance of informal guidance from the IRS, created substantial confusion among taxpayers and practitioners. This caused the IRS to release Announcement 2009-51, allowing taxpayers to rely on the earlier definition of U.S. persons for all FBARs due on June 30, 2009.
The IRS has granted some relief to certain persons for filing FBARs. In Announcement 2010-16, the IRS temporarily suspended the filing requirement for persons who are not U.S. citizens or residents, or domestic corporations, partnerships, trusts, or estates. In addition, Notice 2010-23 further extended the deadline for filing reports originally due on June 30, 2010, and earlier years to June 30, 2011, for persons who have only signature authority but no financial interest in a foreign financial account and for those holding foreign commingled funds. The deadline for 2008 and earlier years had previously been extended to June 30, 2010, in Notice 2009-62 for these foreign financial accounts. The IRS indicated that it intends to limit the interpretation of the term “commingled funds” to mutual funds with respect to FBARs for calendar year 2009 and prior years (2010 reports and earlier). Therefore, investments in foreign hedge funds or private equity funds will not create an FBAR filing requirement. Treasury’s Financial Crimes Enforcement Network (FinCEN) has issued proposed regulations to clarify some of the confusion related to the FBAR filing requirements, specifically defining “U.S. persons,” “financial interest,” and “signature authority.” Taxpayers and practitioners should continue to monitor the situation to ensure compliance with the rules.
The HIRE Act
On March 18, 2010, President Obama signed into law the Hiring Incentives to Restore Employment Act of 2010, P.L. 111-147 (the HIRE Act), which contains the Foreign Account Tax Compliance Act of 2009 (FATCA). The HIRE Act has made sweeping changes to withholding taxes on payments made to foreign recipients, penalties for failure to file certain information returns, foreign reporting requirements, and in some instances a tolling of the statute of limitation, all in an effort to enforce compliance. Many of these changes do not take place for two or more years, but taxpayers should be aware of the implications now to avoid future issues. This item addresses many of the more far-reaching portions of the HIRE Act, although certain changes resulting from this act are beyond the scope of this article and are not addressed here.
Expansion of Reporting Requirements for Foreign Financial Assets
The HIRE Act has expanded the reporting requirements for individuals with an interest in a specified foreign financial asset that exceeds $50,000. The new reporting requirement applies for tax years beginning after March 18, 2010 (effectively calendar year 2011). Although some of the information required under the new rules is similar to what is provided for FBAR filings, the requirements are not identical. Under the new rules, individuals must report certain information directly on their federal income tax return if the aggregate value of all “specified foreign financial assets” exceeds $50,000. This is an additional reporting requirement and does not replace the FBAR filing requirement.
An individual who fails to make the required disclosures will be subject to a $10,000 penalty for the tax year. In addition, any individual who fails to disclose, receives a notification of the failure, and does not file a disclosure within 90 days of receiving the notice will be assessed a penalty of $10,000 for each 30-day period (or fraction thereof) during which the disclosure is not made. The maximum penalty is $50,000; however, it may be waived if the individual can establish reasonable cause for not filing. Relying on foreign laws that prohibit the disclosure of the information is not considered reasonable cause for purposes of avoiding the penalties.
Specified foreign financial assets include:
- Any depository, custodial, or other financial account maintained by a foreign financial institution;
- Any stock or security issued by a foreign person;
- Any financial instrument or contract held for investment that has an issuer or counterparty other than a U.S. person; and
- Any interest in a foreign entity.
The information the individual must disclose for each specified foreign financial asset includes:
- For accounts, the name and address of the financial institution in which the account is maintained, as well as the account number;
- For stocks and securities, the name and address of the issuer and necessary information to determine its class or issue;
- For any other instrument, any information necessary to identify it and the names and addresses of all issuers and counterparties; and
- The maximum value of the asset during the year.
If the IRS determines that an individual has such foreign assets and does not provide sufficient information to show the aggregate value of the accounts, the foreign assets will be deemed to be in excess of the $50,000 requirement and will be subject to the penalties for failure to disclose.
Penalties on undisclosed foreign financial assets understatement: For tax years beginning after March 18, 2010, a 40% penalty will be imposed on any understatement of tax attributable to foreign financial assets that were required to be, but were not, disclosed under the new reporting requirements discussed above or the requirements under Secs. 6038, 6038B, 6046A, or 6048. The understatement is attributable to a foreign financial asset if it is attributable to any transaction involving the asset.
Annual PFIC reporting requirements: The HIRE Act requires that as of March 18, 2010, every U.S. shareholder of a passive foreign investment company (PFIC) is required to file an annual information return for the PFIC in order to report the information required under new Sec. 1298(f). Under prior law, reporting by U.S. shareholders was required only in certain situations as provided in the instructions to Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund. However, subsequent to the HIRE Act, the IRS issued Notice 2010-34, providing that U.S. shareholders should continue to follow the instructions to Form 8621 to determine if they are required to report their interest in a PFIC for tax years beginning before March 18, 2010.
Extension of the statute of limitation related to foreign reporting requirements: In general, the statute of limitation for the assessment of tax is three years from the date the taxpayer files the return. The HIRE Act made two changes to the general rule. First, in the case of returns filed after March 18, 2010, and those that are filed before this date for which the statute of limitation has not yet expired, the statute of limitation for the entire tax return is suspended for failure to provide certain information related to foreign operations or transactions. If a taxpayer fails or has failed to report information on foreign financial assets, PFICs, or interests in and transfers to foreign entities that must be disclosed on any of the following forms, the statute of limitation for the entire tax return does not begin until the omitted information has been provided.
- Forms 926, Return by a U.S. Transferor of Property to a Foreign Corporation;
- Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts;
- Form 5471, Information Return of U.S. Persons with Respect to Certain Foreign Corporations;
- Form 5472, Information Return of a 25% Foreign-Owned U.S. Corporation or a Foreign Corporation Engaged in a U.S. Trade or Business;
- Form 8621, Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund;
- Form 8858, Information Return of U.S. Persons with Respect to Foreign Disregarded Entities; or
- Form 8865, Return of U.S. Persons with Respect to Certain Foreign Partnerships.
Prior to the passage of the HIRE Act, the statute was extended only for the portion of the return related to the information that had been omitted.
Second, the statute is increased to six years if there is an omission of gross income in excess of $5,000 from foreign financial assets that are required to be disclosed or for which disclosure would be required but for the minimum $50,000 threshold. The current rules regarding the extension of the statute when a taxpayer omits an amount of gross income greater than 25% of the gross income reported on the return still apply.
These changes will likely have a significant impact on tax compliance but will also affect tax provisions. Uncertain tax positions under FASB ASC Topic 740 (Income Taxes) may end up remaining as liabilities for extended periods of time, or indefinitely if it is determined that information returns have not been filed.
Reporting requirement changes for foreign trusts treated as having U.S. beneficiaries: Effective March 18, 2010, the HIRE Act provides that an amount will be treated as accumulated for the benefit of a U.S. person even if that person’s interest in the trust is contingent on a future event. In addition, if any person has the discretion to make a distribution from the trust to, or for the benefit of, any person, the trust will be treated as having a U.S. beneficiary, unless the terms of the trust specifically identify the class of persons the distribution may be made to and none of those persons are U.S. persons during the tax year. If any U.S. person transfers property to the trust (directly or indirectly) and is directly or indirectly involved in any agreement or understanding (written, oral, or otherwise) that may result in trust income or corpus being paid or accumulated to, or for the benefit of, a U.S. person, that agreement or understanding will be treated as a term of the trust.
Presumption of a U.S. beneficiary: Effective March 18, 2010, if a U.S. person transfers property to a foreign trust (directly or indirectly), the IRS may treat the trust as having a U.S. beneficiary for purposes of applying these tax rules to the transfer. However, the presumption will be not made if the U.S. person submits to the IRS any information the IRS requires regarding the transfer, and the U.S. person demonstrates that no part of the trust’s income or corpus may be paid or accumulated during the tax year to, or for the benefit of, a U.S. person under the terms of the trust, and that no part of the trust’s income or corpus could be paid to, or for the benefit of, a U.S. person if the trust were terminated at any time during the year.
Uncompensated use of trust property treated as distribution: The HIRE Act provides that any loan of cash or marketable securities or the use of any other trust property (directly or indirectly) by a U.S. grantor, a U.S. beneficiary, or any U.S. person related to them is treated as a distribution to the U.S. person, unless the U.S. person repays to the trust the fair market value of such use within a reasonable time period. If the distribution treatment does not apply to the use of the property, the return of the property will be disregarded for federal tax purposes. In addition, for purposes of determining whether a foreign trust has a U.S. beneficiary, a loan of cash or marketable securities or the use of any trust property by a U.S. person is treated as a payment from the trust to the U.S. person in the amount of the loan or the fair market value (FMV) of the use of the property. This rule does not apply if the U.S. person repays the loan at a market rate of interest or pays the FMV of the trust property’s use within a reasonable period of time. This provision applies to loans and the use of property after March 18, 2010.
Reporting requirement for U.S. persons treated as owners of foreign trusts: For tax years beginning after March 18, 2010, any U.S. person who is treated as the owner of any portion of a foreign trust under the grantor trust rules at any time during the person’s tax year must submit any information required by the IRS for the foreign trust for that year. This is in addition to prior requirements providing that U.S. persons treated as owners of foreign trusts are responsible for ensuring that the foreign trust complies with its own reporting obligations.
Penalty for failure to report information or file return concerning certain foreign trusts: For notices and returns required to be filed after December 31, 2009, the minimum penalty for a U.S. person’s failure to file reports for transfers to and distributions from foreign trusts, and to foreign trusts of which the U.S. person is an owner under the grantor trust rules to file reports, is $10,000, not to exceed the gross reportable amount.
The reporting requirements enacted under the HIRE Act will require those affected to make significant changes to their current systems and procedures in order to comply with the new rules. It will be very important going forward to stay informed as the IRS provides additional guidance on these new provisions. It will also be very important to ensure that all required disclosures are made for all foreign financial assets so as not to increase the statute of limitation on the return. Taxpayers should pay close attention as the IRS and FinCEN provide guidance on the FBAR requirements going forward.
Editor: Frank J. O’Connell Jr., CPA, Esq.
Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.